Enter the stock picker
Though the environment has shifted dramatically, security selection again comes to the fore.
Almost exactly 12 months ago, after the bull got up off its feet and rallied 40% off its pandemic low, I wrote the following few months were likely to be more volatile, prompting a shift in focus to individual securities rather than specific groups. With the S&P 500 having risen this year to within 7% of our 4,500 outlook for 2021, we again think the best opportunities may well lie in specific names rather than broad sectors, in particular companies capable of maintaining pricing power amid rising inflation. This is partly because we expect volatility will stir up anew as we move into summer, this time over macro/policy risks (more below), not a new wave of Covid-19 cases as was the case a year ago.
To be sure, our model portfolios remain tilted toward cyclical Value sectors and industries (Financials, Energy, Materials, Industrials, travel & leisure and semiconductor chips), and have been using this month’s pullbacks in these areas to reload and add to bets. Earnings season has been spectacular but guidance conservative; we think this is a good setup for the rest of the year as we expect the overpowering strength of the recovery to drive continued earnings upgrades. As for key risks ahead, we see three:
- Choppier markets Because near-term news flow is more important for Value stocks, Value-driven markets tend to be choppier than Growth-driven markets. So, investors should be prepared for volatility, which has been trending down for a year, to begin to tick up as the two risks below rear their heads.
- Inflation We are far less sanguine than the Fed on the longer-term inflation risk. We are exiting this artificial recession with extraordinary levels of cash balances in both the household and corporate sectors, the largest Fed balance sheet in history and unprecedented levels of continued fiscal spending. At a bottom-up level, many companies are reporting significant issues with inventory availability and commodity pricing; we expect wage pressures to be next. The Fed has taken on a third mandate, which is very inflation friendly, and is therefore likely to be very slow to react as again was confirmed in Chair Powell’s post-meeting press conference today. This means the party is likely to continue for risk assets, but at some point, the hangover could be substantial if—perhaps more likely when—either the Fed blinks or the bond market vigilantes take over.
- Tax/regulatory policy Near term, the market is more focused on the overwhelming nature of the recovery, not what it expects to be a moderate level of tax increases relative to President Biden’s aggressive proposals. In addition, many market participants misread the lagged impact on the economy of tax and regulatory policy. For instance, what is presently being characterized as “the Biden Boom” can be largely attributable to the lagged impact of the Trump reforms, alongside the sudden end of Covid lockdowns as the vaccines roll out. If President Biden does put through a substantial tax increase, the market may not initially react too negatively given the strong economic growth already underway. However, if the increases go through, we’d expect a lagged, negative impact on forward economic and earnings growth and would lower our longer-term market outlook accordingly. We’re waiting to see how this evolves in the Congress this summer before doing so.
The bottom line is, it’s not a “Sell in May and go away” market. There is too much upside to earnings and the broader economic story. The issue in the months ahead will be determining in which companies will these forces work best. In other words, it’s shaping up to be a stock picker’s market. The key will be to choose wisely.